THE EFFECT OF INFLATION AND INTEREST RATE ON ECONOMIC GROWTH IN NIGERIA

 

CHAPTER ONE

INTRODUCTION 

Background of the Study

Economic growth of any country reflects its capacity to increase production of goods and services. The simplest definition of economic growth can be stated as the increase in the Gross Domestic Product (GDP) of that country. Nominal GDP is usually adjusted for inflation factor to reflect real GDP. Interest rate is one of the macroeconomic growth factors; it’s up and down volatility is closely related with inflation rates. Its high or low rates also impact the economic boom (high GDP) and extending to influence economic growth rate. In business fields, it is very important to accurately predict interest rate trends. An interest rate is described as the price a borrower pays for the use of money he does not own, and has to return to the lender who receives for deferring his consumption, by lending to the borrower. Interest can also be expressed as a percentage of money taken over the period of one year (Devereux & Yetman, 2012). 

            An interest rate is very well stated as the rate of increase over time of a bank deposit. An Interest, which is charged or paid for the use of money, is often expressed as an annual percentage of the principal. It is calculated by dividing the amount of interest by the amount of principal. Interest rates often change as a result of the inflation and Government policies. The real interest rate shows the nominal interest rate – inflation. A negative real interest rate means that the nominal interest rate is less than the inflation rate (Gagnon and Ihrig, 2004). Interest rate is the tool used by the central bank of a country to keep a check on any major currency fluctuation. An increase in interest rate is necessary to stabilize the exchange rate depreciation and to curb the inflationary pressure and thereby helps to avoid many adverse economic consequences.

The ability and capacity to increase the level of production of quality service and tangible goods, is pertinent to the growth of any economy. Economic growth can therefore be viewed as an increase in the Gross Domestic Product (GDP) of a particular country. Inflation and Interest rate are essential macroeconomic variables capable of changing, transforming and redirecting the growth pattern of a country’s economy. One of the major macroeconomic objectives of any country (Nigeria inclusive) is to have a sustained level of economic growth combined with low levels of Inflation and a reasonable level of Interest rate. Hence the behaviors’ of both Inflation and Interest rate to a large extent affect the economic growth of a country (Okpe, 2018).

According to Jayathileke & Rathnayake (2013), most developing countries especially Nigeria, are easily affected by supply shocks which leads to high variability in inflation hence disturbing the consumption, investment and production behaviour. However, due to government intervention in the financial and goods markets, macroeconomic reactions may cause economic instability and market failure. Although mild inflation is a healthy and natural phenomenon of any developing economy, no matter how strong and stable it may be. Thus it could be said that a slight inflation is “greasing the wheels of commerce.” The risk attached to this is that stable prices and zero inflation rates might trigger deflation, economic depression, general recession, technical insolvency and even bankruptcy.

Macroeconomists, central bankers and policymakers have often emphasised the costs associated with high and variable inflation. Inflation imposes negative externalities on the economy when it interferes with an economy’s efficiency.  Examples of these inefficiencies are not hard to find, at least at the theoretical level. 

Inflation can lead to uncertainty about the future profitability of investment projects (especially when high inflation is also associated with increased price variability).  This leads to more conservative investment strategies than would otherwise be the case, ultimately leading to lower levels of investment and economic growth.  Inflation may also reduce a country’s international competitiveness, by making its exports relatively more expensive, thus impacting on the balance of payments.  Moreover, inflation can interact with the tax system to distort borrowing and lending decisions.  Firms may have to devote more resources to dealing with the effects of inflation (for example, more vigilant monitoring of their competitors’ prices to see if any increases are part of a general inflationary trend in the economy or due to more industry specific causes).

Economists have diverse views about the concept of inflation. The monetarists opined that inflation is harmful to economic growth while the structuralists argue otherwise. Therefore existing literature opined that relationship of economic growth with inflation can either be positive or negative as the case maybe (Mortaza, 2005). However, interest rate is another macroeconomic growth factors (as earlier identified), it’s up and down volatility is closely related with inflation rates. Its high or low rates also impact the economic prosperity and extending to influence economic growth rate. In business fields, it is very important to accurately predict interest rate trends. Unfortunately therefore, previous studies have assumed that the time series data is stationary and they ignored that non stationary could exist in the variables. Inflation means a sustained increase in the aggregate or general price level in an economy. Inflation means there is an increase in the cost of living. There is widespread agreement that high and volatile inflation can be damaging both to individual businesses and consumers and also to the economy as a whole. 

 Aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's portfolio (Gudmundsson, 2012). 

Generally, the inflation rate is used to measure the price stability in the economy. A low inflation rate scenario will exhibit a rising currency rate, as the purchasing power of the currency will increase as compared to other currencies. 

Statement of the Problem

The effect of Inflation and Interest rate on economic growth in Nigeria is a serious menace. There is a general consensus that high Inflation rates and Interest rate cause problems for aggregate economic performance, although there is much less agreement about the relationship among Inflation, Interest rate and economic growth and how it affects economic activities at the macroeconomic level. This has generated a significant debate both theoretically and empirically.

The level of the country’s inflation is no longer the problem, but the fact that inflation has reached a crisis stage. Since the mid-1960’s, Inflation has become so contentious in Nigeria and the recent rate of Inflation has been a cause of great concern to many. The change in Interest rate determines the rate of Inflation, as the Nominal Interest rate is a function of the Real Interest rate and the Inflationary expectations (Fisher, 1993). Nominal Interest rate adjusts to change in rate of Inflation; the higher the rate of Inflation, the higher will be the Nominal Interest rate. The historical experience shows that Nominal Interest rate and Inflation are closely associated, bringing to light how economic activities are affected by this relationship.

Since independence, Nigeria has been suffering from high Inflation and Interest rate even after the several interventions by the Central Bank of Nigeria (CBN). Measuring real economic growth in Nigeria, aims to access whether growth can cope with the growing demands of the society including population and how to maintain growth in the face of Inflation and Interest rate.

Objectives of the study

The broad objective of this study is to investigate the impact of inflation rate and interest rate on economic growth in Nigeria. Specifically, the study seeks to:

i.              examine the effect of Inflation rate on growth in the Nigerian economy

ii.            examine the impact of interest rate on economic growth in Nigeria

iii.         identify the major determinants of inflation rate and interest rate in Nigeria respectively 

Research Questions

i.     What degree of effect does Inflation have on the growth of the Nigerian economy?

ii.  What is the impact of interest rate on economic growth in Nigeria?

iii.   What are the major determinants of inflation and interest rate in Nigeria?

Research Hypothesis

Ho-1: There is no significant effect of interest rate on economic growth.

Ho-2: There is no significant effect of inflation rate on economic growth.

Significance of the Study

            So the study will be of importance to educate the economic planners to know that interest rate is great useful in the mobilization of financial resources in the promotion of the economic growth rather than going outside the country seeking for fund to borrow.

To the government, this studying will be of good help to the Nigeria government, especially the present government to know that inadequate supply of locally produced and imported commodities, the high price of imported commodities, the high price of imported goods arising from increases in foreign prices causing instability of foreign exchange, thereby affecting our economy and its growth.

To the academia, this study hopes to assist in the knowledge and provide help for other researchers to complete their study. Thus, it will be of immense benefit to student who intent to do more research in this area and thus serve as reference material in the areas.

To the policy makers, as it will assist them with the basic knowledge and skills needed to tackle the pressing issue of inflation rate and interest rate in Nigeria.

Scope of the Study

The study is designed to cover the effect of inflation rate and interest rate in Nigeria economy. The study will make use of Nigeria data spanning through 1981 to 2016.